Wednesday, May 6, 2015

What should I do with extra cash? Save, Pay off Debt or Invest?

When it comes to personal finances, people always want to know whether they should put extra cash towards savings, investments or paying down debt. Here are some of my thoughts on what you should do with any extra cash that may come your way.

The number one priority for everyone should be to have 3 months of household expenses set aside in a plain old savings account. This is for emergencies. It's not for spending, investing or anything else. Just a safety net. Even if you would qualify for employment insurance benefits if you lost your job, you should have this amount of money tucked away for emergencies.

Debt

I categorize debt into two different columns based on what it was used to buy. You've probably read about ideas like Robert Kiyosaki's who say that home mortgages are bad debt because houses are not assets. I don't completely agree with him.

I take the stand that if debt is used to buy a house that ends up costing less than renting an equivalent accommodation then the savings is equivalent to an income. A home that allows you to save money over renting is an asset, to a degree.

I never advocate getting into debt for consumer products, vacations or a car that has features beyond what you absolutely need. I only recommend borrowing for cars to people that need them for work. Lots of people live without cars and you can too for a time while you save up for one you can afford to buy with cash.

Dave Ramsay says that you pay off the debts with the highest interest rates first and then the ones with low rates after. I agree with this completely and I'll add another twist. There are some debts you should not pay down faster than you have to because the central bank may be helping you with them.

There is a difference between what the government tells us is the rate of inflation or Consumer Price Index and the rate at which the M3 money supply is expanding.

In the Austrian school of economic thought, inflation is simply the expansion of the money supply. If you are able to borrow at an interest rate of say 2.79% and the money supply is expanding at 4% then you should not pay down this debt any faster than the loan conditions demand.

The reason is simple, the central bank is eroding the burden of this debt for you and you should ride this wave of free debt relief. To see what the actual rate of inflation is based on the old rules from 1990, visit www.shadowstats.com

All debts with interest rates over the actual inflation rate should be paid down before you start investing because destroying debt is the only 100% guaranteed way to earn an inflation-beating rate of return on your money. For example, if you paid off an 8% debt you just earned an 8% rate of return.

Investing

Only once you have 3 months of expenses saved and you have paid off all debts which are at interest rates higher than the true rate of inflation should you start investing.

I'll talk more about this down the road but if you've read my book Invest Local you'll know that I advocate a true diversification among the 8 asset classes, not just stocks and bonds.